Tightening cryptocurrency regulations

The recent theft of roughly ¥58 billion worth of cryptocurrency holdings from a Tokyo-based virtual currency exchange — the largest-ever heist of its kind — makes the case for more steps to tighten oversight of such exchanges, including stricter security requirements, for the protection of investors. At the same time, care should be taken so that excessive regulations will not result in stifling the potential of cryptocurrencies to enhance the convenience in financial services.

The disclosure last weekend by Coincheck Inc., one of the nation’s largest cryptocurrency exchanges, that a hack had illegitimately transferred ¥58 billion worth of its NEM virtual currency — all client assets — sheds light on the problems in the security of such exchanges. The amount stolen eclipsed the ¥48 billion that bitcoin exchange Mt. Gox lost in February 2014. Just three days after the theft was reported, the Financial Services Agency issued a business improvement order for Coincheck. Executives of Coincheck say the firm will use its own capital to reimburse ¥46.3 billion — reflecting the decline in NEM’s unit value since the hack was reported — to all 260,000 customers who lost their money. However, the company has not specified any timeline or procedures for the reimbursement.

A cryptocurrency is a piece of electronic data bearing financial value and traded on the internet. Unlike legal tenders like the yen and the dollar, there are no public authorities like the government or the central bank that control cryptocurrencies. Their transactions are managed and recorded in a decentralized system using blockchain technology.

Cryptocurrencies were launched as tools that allow quick and easy settlements of web-based payments and money transfers. As interest rates remain at ultra-low levels, however, virtual currencies have drawn attention as one of the few investment tools that can produce sizable gains. The steep growth in cryptocurrency transactions — and the subsequent surge in prices — is the result of speculative investments by individual investors. Virtual currencies are rarely used as payment tools, but attract vast amount of funds mostly in speculative transactions.

Wild fluctuations in cryptocurrency prices have also raised concern. Whereas a company’s performance and earnings forecasts serve as a guide in the trading of its stocks, the value of a cryptocurrency is not backed by specific assets. Since there are no solid grounds that predict their future value, transactions in virtual currencies tend to be driven largely by the whims of investors. As a result, their prices tend to go up and down dramatically as investors respond to moves by government authorities to tighten regulations on cryptocurrencies. Aggregate market value of cryptocurrencies dropped by roughly 10 percent at one point Friday evening upon the news of the massive theft at Coincheck.

The overheating of the cryptocurrency market with speculative money and the wild price fluctuations have raised alarms and calls for tightening of regulations in many countries from the viewpoint of financial system stability. China and South Korea have already tightened their regulations on cryptocurrencies, and Germany and France are reportedly set to propose new international regulations for discussion at the Group of 20 meeting of finance ministers and central bank chiefs in March. Aside from the instability of cryptocurrency prices, concern is growing particularly in Europe that virtual currencies could be used in money laundering and funding for terrorist activities.

Last year, Japan revised its Payment Services Act to legally define cryptocurrencies as a means of financial settlement, requiring virtual currency exchanges to register with the government and submit annual reports. As of mid-January, Japan had 16 registered cryptocurrency exchanges, making the nation a major player in the field. Coincheck is not among the registered exchanges but its application for registration is being reviewed by financial regulators.

Security lapses at virtual currency exchanges like the problem that took place at Coincheck will require tighter oversight of the exchange operators from the viewpoint of investor protection. Tighter market regulations to restrict speculative transactions may also be unavoidable, since they deviate from the originally intended purpose of cryptocurrencies and their price instability threatens their use as a reliable tool in financial payment. But excessive regulations that could restrict the potential of cryptocurrencies to enhance financial service convenience should be avoided. Regulations on virtual currencies should be considered in a balanced manner that addresses the problems that have been exposed while weighing the impact on their future potential to radically change financial services.